Short Finisar: A Whole Lot Of Nothing

| About: Finisar Corporation (FNSR)

Summary

52-week highs are a result of herd-like behavior from sell-side analysts.

Very little about the company's operational improvement is sustainable.

I believe that the intrinsic value of this stock is somewhere between $16 - $22.

All quanitiative information was pulled from the company's 10-K, 10-Q and DEF 14A.

Before the comment section gets aggressive I think it's important to acknowledge two items: Yes, there is an impending increase in the telecom spending cycle. Yes, margins have improved meaningfully for Finisar (NASDAQ:FNSR) this year. The point is that despite this "new" and "attractive" story, little to none of this hype is sustainable and I fear that retail investors will be burned once again after this fire fizzles.

How we got here

The stock has run up an incredible 200% in the past year. The current price is a function of sell-side research upgrade momentum and unfortunate retail investors who do not do enough due diligence. This is not an instance where the company is a complete dud. Rather, this is a stock that has ripped significantly more than even the most aggressive fundamentals can allow, and like all mispricings, this too will dissipate.

And while investors have been buying into this story, insiders have been selling - a lot. Since the beginning of 2015 insiders have sold $16mm worth of stock in close to 60 separate transactions from nine different executives. In the same time period there were zero open market purchases made. How about that as a vote of confidence?

Lastly, telecom/datacom is a highly cyclical industry. Despite the growth in data, spending occurs in waves and for this reason margins compress and expand over time. Don't even listen to me, hear it from management themselves on the most recent conference call:

Kurt Adzema: "I think we've talked for long time about historically our (gross) margins have been between 30% and 35%, and when we're going through these cycles where we have new products out there with better gross margins and our revenue is growing at a strong pace then we tend to be towards the upper end of that range and that's what we're seeing now. Last year when we didn't have the newer products we were at the lower end of the range…(Margins are) highly dependent on the products that we're talking about and both datacom and telecom have products that have margins meaningfully higher than our current margins and meaningfully lower. So it's really a product-by-product basis."

Mr. Adzema says it himself, there is no big break through. This is still the same business, but the market has suddenly decided to give it a value of $3.8bn versus the $1.35bn it gave the company in October and November of last year.

For cyclical industries, valuation multiples are expressed as a function of where we are in the cycle. With margins at cyclical highs and the stock currently touching its upper band of historical valuation, the crutch of this thesis is that markets are wrongly extrapolating present outcomes as the normal distribution for future expectation, leaving little margin for error and plenty of downside.

Valuation

I am a believer that stocks mean revert to the intrinsic value of the cash flow they produce, discounted into perpetuity. Today, Finisar is trading at levels far above its intrinsic value. Intrinsic value is derived from free cash flow, or the amount of money that can consistently and sustainably be derived from the company's operations after they reinvest in their business. To gauge this, three very important line items must be assessed: revenue growth, EBITDA margins and capital expenditures. Evaluating a company can begin only after taking into account the company's expenses and capitalized items.

A quick note: Comps sets and the ratios that come with it are largely misunderstood. Discount brokerages push these onto retail investors to give investors a rough valuation guide for company comparison. I will ignore arguments such as P/S, P/E, PEG ratio and P/B in this article because they are all proxies for discounted cash flow calculations such as the one below.

Historical averages

Over the past five years, the company has averaged 7.8% YoY growth in revenue, or a 5.8% compounded annual growth rate ("CAGR"). During this time, cost of revenues (also known as cost of goods sold) averaged 69.8% of sales, research and development averaged 16.1% of sales, and general and administrative expenses and sales and marketing averaged 4.8% and 4% of sales, respectively. Together, these major line items total 94.7% of sales, leaving a meager 5.3% average historical EBITDA margin. When adding non-cash expenses such as amortization of acquired technology, impairment of long-lived assets, and restructuring recoveries, margins shrink even further to 4.4%.

Moving onto the balance sheet, changes in capital expenditures - or the amount the company invests into the business annually - averaged about 4.6% of sales. Using EBITDA margins - capital expenditures as a rough estimate for free cash flow actually leads to a negative number, or slight cash burn (4.4% - 4.6% = -0.2%).

When applying the historical averages as the "steady state" for the company's line items and modeling the cash flows forward, the value of the stock changes drastically:

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To determine whether this is realistic, I assessed asset turns. The company's five-year historical average is 2.74x, and in this model by the end of year ten, asset turnover expands to 4.46x. This is frighteningly high and a potential sign that the company will either need to grow its long-term assets (decreasing FCF) or lower sales growth for historical asset turn levels to normalize.

Many bulls will be quick to note that the sell-side analysts are under the impression that revenue growth will exceed 12%, and that this should surely increase the value of the stock. However, in this situation the revenue growth is a non-issue because the margin through which the company is attaining revenue (EBITDA margins) does not exceed the cost at which they are attaining such revenue (changes in capital expenditures as a percentage of sales).

Financial theory states that a company will simply not invest when there isn't a sufficient return on investment, but the investing world is so fixated on revenue growth and earnings per share that theory is consistently proven false. As a general rule of thumb, unless management is compensated such that the return on invested capital must exceed a minimum threshold, it is foolish to expect this aforementioned bit of financial theory to be upheld.

Nonetheless, giving the company the benefit of the doubt and applying a 12% revenue growth, I used an optimization formula to determine what the company's EBITDA margins would have to be (assuming that capital expenditures remain unchanged as a percentage of sales) in order for the current stock price to make sense.

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As you can see from the model above, EBITDA Margins need to improve from the historical average of 4.4% to an incredible 15.2%, or a whopping 1080 basis point (bps). And this is even with a 3% terminal growth rate.

How likely is this? In my opinion, this is essentially impossible. Asset turnover confirms this because in this model as it skyrockets to 5.78x (unrealistically above the five-year high of 3.15x).

So where is fair value? To determine this, I zeroed out all non-cash expenses and selected the five-year low for all other expenses as a percentage of sales:

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The above is richly optimistic (and borderline unrealistic as steady state assumptions), but as most in the finance world know, equity investors are crazed optimists. This leads to a value of the company at $16/share or just about half of the current value.

By changing revenue growth to meet analyst expectations of 12% from the historic 7.8% historic average growth for the next 10 years, the share price changes to about $22/share:

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Non-GAAP Measures

My amazement with management teams of public companies continues. In an attempt to give investors "a clearer view" of operations, management strips out non-cash expenses when calculating non-GAAP expenses. I argue that these non-cash expenses are in fact very real.

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The picture above is from the company's most recent 10-K. I lay out my argument for including some of these expenses when analyzing the company below:

Stock-based compensation expense - the company's DEF 14A shows that the company compensates executive primarily in stock. To be considered competitive, if the company stopped offering this stock compensation they would be required to increase management's base pay, which would flow directly into general and administrative expense on the balance sheet. How the Street lets them get away with this is beyond me.

Impairment of long-lived assets/amortization of acquired technology, hile on average these two items together are about 90 bps of sales, the purchase of equipment/other companies is a very real expense despite management choosing to capitalize such items on the company's balance sheet. Any impairment or amortization is either a misjudgment of value or technology that they will eventually be required to replace.

Conclusion

The stock trades above $32/share, and I believe that true value is somewhere between $16 and $22.

The stock has been blessed with an unusual bull market over the course of this year and upgrades from myopic sell side analysts, and because of this I believe that Finisar will underperform going forward.

As Benjamin Graham once said, you certainly don't need a scale to tell when a man is overweight. Finisar, in this case, is significantly overweight.

Disclosure: I am/we are short FNSR.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.